Friday, April 20, 2007

How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 3 of 3

Now that everyone comprehends the basics of options, what some simple strategies are, and how they leverage gains and losses, I can start explaining some more complicated strategies.

Butterfly Spread
If the investor is confident that a particular stock is going to be the same price today, sometime in the future, the investor could: long the stock and make no money, short the stock and have the ability to make money elsewhere, or use options to make money on the non-movement itself. To do this an investor would take long position at strike prices where the investor feels the stock will not pass given the time interval (if you think the stock will not go past $27 and $29, you would buy calls at strike prices of $26 and $30). The investor would also take a "double" short position at the strike price the investor feels the stock will hover around (if you think to stock will hover around $28 you would sell two calls at a strike price of $28). The investor would make the most money if the future stock price stays at the strike price of the shorted call position. The investor will lose money is if the future price breaches the outer long call strike positions. These losses are caped, however, because each move up in the stock price means the long positions' value will go up, but the short position will go down and vise-versa on the lower extremity. The payoffs look like this:

If an investor wants to take the opposite strategy, they would likely create a straddle. A straddle involves longing (purchasing) a call and a put at the strike price you feel the future stock price will be farthest from (usually the strike price closest to the current stock price). In order for the investor to make money on this strategy, he/she needs the future price to be greater than or less the strike price in excess of the sum of the call premium and put premium. Let's say the call and put each cost $3 at a strike price of $65. The investor would need the future stock price to go up to $71 (65+3+3) or down to $59 (65-3-3) to be in the money. The strategy is shown below.
I replicated the straddle strategy last week when I started this trilogy of blog posts. I managed to make more than 9% fluctuation in the stock because of the leverage that options create. Since then, I managed to make money on only one of my next three plays. Luckily, I am only down $30 on options. In short, I recommend that you only do options if you are truly willing to accept the risks you take on to achieve such high returns.

No comments: